The Great Reflation Experiment

The question we have been focused on for some time now is whether we end up
with inflation, or deflation, and what that endgame looks like. It is one of
the most important questions an investor must ask today, and getting the answer
right is critical. This week, we have a guest writer who takes on the topic
of the great experiment the Fed is now waging, which he calls The Great Reflation
Experiment.

One of my favorite sources of information for decades has been and remains
the Bank Credit Analyst. It has a long and storied reputation. One of
their enduring themes has been the debt super cycle. Investors who have paid
attention to it have been served well. I am taking a little R&R this weekend,
but I have arranged for my friend Tony Boeckh to stand in for me. Tony was
chairman, chief executive, and editor-in-chief of Montreal-based BCA Research,
publisher of the highly regarded Bank Credit Analyst up until he retired
in 2002. He still likes to write from time to time, and we are lucky enough
to have him give us his views on where we are in the economic cycles. Gentle
reader, we are all graced to learn from one of the great economists and analysts
of our times. Pay attention. Central bankers do. You can read his extensive
bio at www.boeckhinvestmentletter.com and
I will tell you how to get his letter free of charge at the end of this letter.
And, he told me to mention that his son Rob is now helping him write, so there
is a double byline here. Now, let's just jump in.

By Tony Boeckh and Rob Boeckh

The Crash of 2008/9 should be seen as yet another consequence of long-term,
persistent US inflationary policies. Inflation doesn't stand still. It tends
to establish a self-reinforcing cycle that accelerates until the excesses in
money and credit become so extreme that a correction is triggered. The bigger
the inflation, the bigger the correction. Once a dependency on credit expansion
is well established, correcting the underlying imbalances becomes extremely
difficult. Reflation has occurred after each major correction, and this one
is proving no exception. Return to discipline in the current environment would
be too painful and dangerous. Once on the financial roller coaster, it is very
hard to get off. Moreover, the oscillations between peaks and valleys become
increasingly large and unstable.

Policymakers, money managers, and most forecasters have argued that the crash
was a "black swan" event, meaning that it had an extremely low probability
of occurrence. That is grossly misleading, as it implies that the crash was
so far beyond the realm of normal probabilities that it was unreasonable to
expect anyone to have foreseen it. That argument has been used to justify the
widespread complacency that prevailed in the years leading up to the crash.
Policymakers are still failing to recognize the systemic causes of the crash
and seem to believe that enhanced regulation will prevent history from repeating.
While it is true that regulators were asleep at the switch or looking the other
way, they were not the cause.

The Debt Super Cycle

The real culprit is the US debt super cycle, which has operated for decades,
mostly in a remarkably benign manner. The inflationary implications of the
twin deficits (current account and fiscal), as well as the steady increase
in private debt, have been moderated by the integration of emerging markets
into the global economy. The massive increase in industrial output from China,
India, and others has enabled persistent credit inflation in the US to occur
with virtually no consequence to date (other than periodic asset price bubbles
and shakeouts). How long the disinflationary impact of emerging-market productivity
growth will persist and how long these nations will continue loading up on
Treasuries, will be instrumental in determining the course that the Great Reflation
will take.

Tougher regulation is surely appropriate, but it will not stop the next inflationary
run-up unless the system is fixed. In the final analysis, newly minted money
and credit must find a home somewhere.

Some Background on US Inflation

Inflation, to be properly understood, should be defined as a persistent expansion
of money and credit that substantially exceeds the growth requirements of the
economy. As a consequence of excessive monetary expansion, prices rise. Which
prices go up and at what rate depends on a number of factors. Sometimes it
is the prices of goods and services that are the most visible symptom of inflationary
pressures. That was the case in the 1970s when the Consumer Price Index (CPI)
hit a peak rate of 14% per annum. Sometimes it is the prices of assets such
as homes, office buildings, stocks, or bonds that reflect the inflationary
pressure, as we have seen in more recent years.

When inflation becomes pervasive, and other conditions are supportive, it
can engulf a whole industry. We saw this in the financial sector in the period
leading up to the crash. The supporting conditions or "displacements," to use
the terminology of Professor Kindleberger, were financial innovation, deregulation,
and obscene profits and salaries. These drew millions of bees to the honey.
All great manias are accompanied by malfeasance, in this case the biggest Ponzi
scheme in history and many other lesser ones. It is relatively easy to steal
when prices are rising and greed is pervasive. Overspending and a general lack
of prudence always become widespread when a mania infects the general public.
Rational people can do incredibly stupid things collectively when there is
mass hysteria.

The origins of post-war inflation go back to the late 1950s and early 1960s,
though some would take it back much further. In the 1960s, the US dollar started
to come under pressure as a result of US inflationary policy and foreign central
banks' ebbing confidence in their large and growing dollar reserve holdings.
The US responded with controls and government intervention in a number of areas:
gold convertibility, the US Treasury bond market, the Interest Equalization
Tax, and, ultimately, intervention on wages and prices. These moves clearly
flagged to the world that external discipline would be subjugated to domestic
employment and growth concerns. The policy was formalized when the US terminated
the link between gold and the dollar in August 1971, essentially floating the
dollar and setting the US on a course of sustained inflation. Of course, the
dollar floated down, which, among other things, triggered the massive rise
in general prices in the 1970s.

The next episode of credit inflation began in the 1980s, paradoxically triggered
by the success of Paul Volcker's move to break the spiral of rising general
price inflation through very tight money. He succeeded famously, and the CPI
headed sharply lower along with interest rates, setting the stage for the massive
US debt binge and the series of asset bubbles that followed. It was easy for
the Federal Reserve to pursue expansionary credit policies while inflation
and interest rates were falling.

The Great Reflation Experiment of 2009

Private sector credit, the flipside of debt, maintained a stable trend relative
to GDP from 1964 to 1982 (Charts 1& 2). After that, the ratio of debt to
GDP rose rapidly for the 25 years leading up to the crash, and is continuing
to rise. The current reading has debt close to 180% of GDP, about double the
level of the early 1980s. The magnitude and length of this rise is probably
unprecedented in the history of the world. Even the credit inflation that was
the prelude to the 1929 crash and the Great Depression only lasted five or
six years.

Prior to government bailouts and stimulus, the panic, crash, and precipitous
economic decline of 2008/9 were clearly on track to be much worse than the
post-1929 experience. The pervasiveness of leverage - from banks to consumers
to supposedly blue-chip companies - and the illusion of stability in the system,
were fostered through the 25 years that this credit bubble has grown, basically
uninterrupted. The speed and magnitude of the bailouts and stimulus - the end
of which we won't see for a long time - aborted the meltdown. However, the
story is far from over.

The Great Reflation Experiment ultimately has two components. The first is
a rise in federal government deficits, debt, and contingent liabilities. The
second is an expansion of the Federal Reserve's balance sheet. Both are unprecedented
since World War II. US federal government debt is likely to reach close to
100% of GDP over the next 8 to10 years, according to the Congressional Budget
Office (CBO) and supported by our own calculations (Chart 3). Anemic growth,
falling tax revenue, increased government spending, and bailouts of indigent
states, households, businesses, along with an aging population, will all undermine
public finances to a degree never before seen in peacetime. According to CBO
data, government debt could reach 300% of GDP by 2050 as contingent liabilities
are converted into actual government expenditures. This massive peacetime deterioration
in public finances will have grave consequences for living standards and asset
markets, particularly in the longer run.

In the short run, huge deficits and growth in government debt are necessary.
They will continue to play a crucial role in deleveraging the private sector
and in helping to fill the black hole in the economy that has been caused by
the sharp increase in household savings. Further out, government deficits will
put upward pressure on interest rates. However, much of the economy, particularly
housing and commercial real estate, is far too weak to absorb an interest-rate
shock. Therefore, the Federal Reserve will have to monetize much of the rise
in government debt, making it extremely difficult to unwind the explosion in
the Fed's balance sheet and consequent rise in bank reserves - the fuel that
could be used to ignite another money and credit explosion.

The bottom line is that the Fed is in a very difficult position. Its room
to maneuver is either small or nonexistent, and the markets understand this.
That is why there is a sharp divergence between those worried about price inflation
and those fearing a lengthy depression.

Implications for Investors

Investors are also in an extraordinarily difficult predicament. From the peak
in 2007, household wealth declined by about $14 trillion, over 20%, to the
first quarter of 2009. Tens of millions of people had come to rely on rising
house and stock prices to give them a standard of living that could not be
attained from regular income alone (Chart 4). They stopped saving and borrowed
aggressively and imprudently against their assets and future income, some to
live better, some to speculate, and many to do both. That game is over.

Pensions have been devastated and people's appetite for risk has declined
dramatically. The return on safe liquid assets ranges from 0.60% to 1.20%,
depending on term and withdrawal penalties. Reasonable-quality bonds with a
five-year maturity provide about 4%. Bonds with longer maturities have higher
yields but are vulnerable to price erosion if inflationary expectations heat
up. As for equities, people now understand that blue chip stocks carry huge
risk. GE, once considered the ultimate "bullet-proof" stock, dropped 83% in
the panic, and Citigroup lost 98%. Revelations of massive fraud schemes have
further damaged trust and confidence in markets.

Against this backdrop we offer a few thoughts. First, an increase in price
inflation as reflected in the CPI is a long way off. The degree of excess capacity
in the world is probably the greatest since the 1930s, although excess capacity
does get scrapped during recessions. Western economies will remain depressed
for years, and China will also be important in keeping inflation down. Its
capital investment is larger than the US's in absolute terms. It is currently
40% of GDP and growing at 30% per annum. Profit margins in China will probably
get squeezed, which, together with the huge amount of underemployed labor,
means that the Chinese will keep driving their export machine at full throttle,
continuing to flood the world with high-quality, inexpensive goods. Therefore,
investors who need income are probably safe holding reasonably high-quality
bonds in the five-year maturity range. A bond ladder is a very useful tool
for most people. Holdings are staggered over, say, a five-year time frame,
and maturing bonds are invested back into five-year bonds, keeping the portfolio
structure in the zero-to-five-year range. In this way, some protection against
a future rise in price inflation and falling bond prices can be achieved.

Second, massive monetary stimulus is good for asset prices in the near term
(e.g. stocks, bonds, houses, commodities) in a world of very weak price inflation
and a soft economy. That is true as long as the economy does not fall apart
again, which is very unlikely given all the stimulus present and more to come
if needed. Therefore, investors who can afford a little risk should own some
assets that will ultimately be beneficiaries of the wall of new money being
created and thrown at the economy.

There is a major risk to our relative near-term optimism, and that is the
US dollar. Foreign central banks hold $2.64 trillion, overwhelmingly the largest
component of world reserves. The US role as the main reserve currency country
is compromised by its persistent inflationary policies and current account
deficits, a subject high on the agenda at the recent G-8 meeting in Italy and
referred to frequently by China, Russia, Brazil, and others. Foreign central
banks fear a large drop in the dollar, which would cause them potentially huge
losses on their reserve holdings. They don't want more dollars, and yet they
don't want to lose competitive advantage by seeing their currencies go up against
the dollar. To preserve their competitive position, they have to buy more when
the dollar is under pressure. On the other hand, since the 1930s the US has
never subjugated domestic concerns to external discipline. Officials may talk
of a strong-dollar policy, but their actions always speak differently. Their
attitude towards foreign central banks is, "We didn't ask you to buy the dollars." The
US has typically seen such buying as currency manipulation to gain an unfair
trade advantage.

The most likely outcome is a nervous dollar stalemate or, as Lawrence Summers
once described it, "a balance of financial terror." The most important central
banks will continue to hold their noses and buy the dollar to keep it from
falling too sharply. However, this is a fragile, unstable situation, and the
dollar must fall over time. Investors need to diversify away from this risk.
There are three obvious ways.

The first is investing in high-quality US equities that have a majority of
their earnings and assets in hard-currency countries.

The second is investing in gold and related assets. Gold will probably remain
in a tug of war for some time. On the negative side, it is faced with nonexistent
global price inflation, even deflation, and a sharp decline in jewelry demand.
On the positive side, concerns over U. monetary and fiscal debauchery will
almost certainly heat up. As the odds of the latter increase, gold will be
a major beneficiary, and investors should have a healthy insurance position
in this asset class.

Third, most foreign currencies will also benefit from these fears, and hence
investors can also protect themselves by diversifying into non-dollar assets
in the best-managed countries. Some of these are emerging markets like China,
which are liquid, in surplus, fiscally stable, and still growing well in spite
of the global economic downturn. If and when the world economy begins to recover,
and should price inflation stay low, asset bubbles are likely to recur. Where
and when is always hard to tell in advance. Good prospects are in emerging-market
equities, commodities, and commodity-oriented countries.

So, to sum up, in the next six to 12 months we look for a weak but recovering
US economy, a continued deflationary price environment, pretty good asset and
commodity markets, and continued narrowing of credit spreads. This view is
based on the assumption that the new money created has to go somewhere, a stable
to modestly falling dollar, and an anemic world economic recovery next year.

A buy and hold strategy has been bad advice for the past 10 years. The S&P
is down 45% from its peak in early 2000. The investment world is likely to
remain very unstable in the face of the difficult longer-run problems discussed
above. Investors, whether they like it or not, are in the forecasting game,
and forecasting is all about time lags. The exceptional circumstances of the
current environment make any assessment of time lags extraordinarily difficult,
and mistakes will continue to be costly. For that reason, holding well above
average liquidity, in spite of the paltry returns, is sensible for most people
whose pockets are not deep enough to absorb another hit to their net worth.
They are in the unfortunate position of having to wait until the air clears
a bit and more aggressive action can be taken with higher confidence. Warren
Buffet has properly reminded us on numerous occasions that a price has to be
paid for waiting for such a time, but then most of us aren't as rich as he
is.

A Beach, New York, and Maine

I want to thank Tony and Rob for writing this week's letter. You can go to
their website, www.boeckhinvestmentletter.com and
see some of their recent letters, or send an email to info@bccl.ca and
get put on their regular list for the free letter.

As you are reading this, I am hopefully reading on a beach, relaxing under
an umbrella. Tiffani and Ryan are on a cruise in the Caribbean. They just got
back the wedding videos from last year, and they are a hoot. They had one cameraman
with an old Super 8 camera, so that video looks like something from the 60s.
At some point they will put it on You Tube. Interesting to contrast the old
format with the new.

I get back late Monday, and then leave early Wednesday for a quick trip to
New York and then on to the Shadow Fed fishing weekend organized by David Kotok.
My youngest son, now 15, will be with me for our fourth trip. Maybe this year
I can catch more than he does. So far, it has not even been close in either
quantity or quality.

Each year, we make small bets (bragging rights are more on the line) on where
the markets will be the next year. So far, I am money ahead, as I get a few
calls right. Last year the financial markets were just starting to melt down
as we met. It will be interesting to see if any of us came close this year.
There are some fairly well-known names in the room, so it will be interesting
to see who got it right. And even more interesting to try and figure out where
we will be next year at this time. I will report back.

And that blank spot that was my fall travel calendar? Looks like I will be
going to South America in the fall (Argentina, Brazil, and Uruguay). A few
other dates look to be firming up. It has been way too long since I was in
South America, and I am looking forward to it.

Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA)
a registered investment advisor. All material presented herein is believed
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may change and readers are urged to check with their investment counselors
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John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment
advisor. All material presented herein is believed to be reliable but we cannot
attest to its accuracy. Investment recommendations may change and readers are
urged to check with their investment counselors before making any investment
decisions.

Opinions expressed in these reports may change without prior notice. John
Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have
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